I used to work for banks. Now I write about them, and about finance and economics generally. Although I originally trained as a musician and singer, I worked in banking for 17 years and did an MBA at Cass Business School in London, where I specialized in financial risk management. I’m the author of the Coppola Comment finance & economics blog, which is a regular feature on the Financial Times's Alphaville blog and has been quoted in The Economist, the Wall Street Journal, The New York Times and The Guardian. I am also Associate Editor at the online magazine Pieria and a frequent commentator on financial matters for the BBC. And I still sing, and teach. After all, there is more to life than finance.

Austria Falls Out With Bavaria Over Zombie Banks

There’s a nice little storm brewing in the Eurozone core. Reuters reports that the German province of Bavaria is considering legal action against Austria. And it is seeking support for its action not only from the German federal government, but also from the EU.

The background to this is the failure and nationalization of the Austrian bank Hypo Alpe Adria (HAA) in December 2009. HAA was bought by the Austrian state from the Bavaria-based Landesbank BayernLB for a nominal 1 euro. But it seems that BayernLB left behind about 2.3bn euros in subordinated debt. And the Austrian government wants to bail this in as part of the winding-up procedure for HAA.

There is precedent for bailing-in all sorts of unsecured debt holders in European bank resolutions. Cyprus bailed in large depositors in order to recapitalize the Bank of Cyprus. The Netherlands expropriated the holdings of shareholders and subordinated debt holders in the nationalization of SNS Reaal: legal challenge to this action failed, although the Netherlands government was forced to offer compensation. Spain bailed in subordinated debt holders in the nationalization of Bankia. And the UK’s Co-Op Bank attempted to bail in PIBS and preference shareholders, only to see them take over the bank in a hedge fund-led private sector recapitalization. Sometimes the worm turns.

Not only is there precedent, there will shortly be legislation. The European Bank Resolution Directive contains provisions for bail-in of unsecured debt holders to protect taxpayers as far as possible in future European bank resolutions. The directive itself comes into force in January 2015, and the bail-in provisions one year later, in January 2016. Austria’s action jumps the gun, but that does not necessarily make it either illegal or unwise. Creditors really have to accept that bank failure means losses for them.

But there is a complication. BayernLB’s holdings are guaranteed by the Austrian province of Carinthia. Nor are their holdings the only ones that are so guaranteed. According to Barclays Research (quoted by Reuters), the total amount of sub-sovereign Austrian debt guarantees for legacy bank debt is thought to be of the order of 50.5 bn euros.

Ordinarily, if an unsecured debt is externally insured or guaranteed, the insurer or guarantor would take the loss in the event of a bail-in. But not in this case. Austria has overridden Carinthia’s guarantees of HAA’s debts in order to avoid losses rebounding to Austrian taxpayers.

Insolvency lawyers are puzzled by this. Why is Austria overriding the guarantee rather than allowing Carinthia to accept the first loss then bailing them out if necessary – as the US government did in relation to monoline insurers and Detroit?

But Detroit is not the right model for this case. The correct model is actually Iceland, which reneged on cross-border deposit insurance when its banks failed in 2008. The UK and the Netherlands took Iceland to the EFTA court to seek compensation. Final judgement was given in January 2013 – and Iceland won. The Icesave lawsuit established the right of a European sovereign to renege on deposit insurance in a systemic crisis – a right that was subsequently upheld by the EU in the Cyprus bank crisis. After an initial attempt to renege on deposit insurance, which was met with fierce opposition in the Cyprus legislature, deposit insurance in Cyprus was eventually honored not by the sovereign, but by bailing in large depositors.

To be sure, Austria is not reneging on deposit insurance. But if a sovereign can legally default on deposit insurance, it can legally default on sovereign guarantee of junior bank debt too. The EFTA court’s judgement in effect renders null and void sovereign guarantees of all unsecured bank debt, especially junior debt: no way can the guarantees afforded to junior debtholders be allowed to stand when deposit insurance is at risk. I am no lawyer, but it seems to me that the Icesave judgement means sovereign guarantees for BayernLB’s holdings are unlikely to be upheld in a court of law.

Admittedly, the deposit insurance judgement only applies in “systemic crisis”. Bavaria’s case may therefore depend on whether the 2009 nationalization of HAA was due to “systemic crisis”. Given that it occurred in the aftermath of the 2008-9 financial crisis and at the height of the recession caused by that crisis, it is hard not to conclude that it was a systemic crisis. Bavaria’s case looks very thin to me.

The legal implications of Austria’s action were not lost on Moody’s. In addition to downgrading HAA’s subordinated debt to “default”, it downgraded its senior unsecured debt to one or two notches above default. It also downgraded senior and subordinated debt in 11 of Austria’s banks, including Erste Bank and Raffeisenbank, by one notch. And it cut to junk the debt rating of Austria’s other nationalized basket case bank, Kommunalkredit Austria AG. According to Bloomberg,

Moody’s cited “the unprecedented nature” of the Austrian government’s draft law voiding 890 million euros ($1.2 billion) of bonds at Hypo Alpe-Adria-Bank International AG that were guaranteed by the province of Carinthia.

“Austrian authorities are now generally more willing to countenance bank resolutions in which losses may also be imposed on senior creditors,” the ratings company said in a statement.

So Austria’s action has already had severe consequences for its own banks. And it may have other consequences too. There are extensive sub-sovereign guarantees in the Austrian banking system. Undermining them could put the entire sector at risk and diminish investor trust in Austria.

But BayernLB is a German bank. Why is Bavaria contemplating probably fruitless, and certainly expensive, legal action? And why does it think the German government – and even the EU – will back it?

Austria is not the only country with extensive sub-sovereign bank debt guarantees. The German banking system also has extensive guarantees. And one particular part of the German system is very dependent on them.

The German Landesbanken – of which BayernLB is one – were severely damaged in the financial crisis but were never properly resolved. They are widely believed to be zombies which have only survived because the German economy has been strong, the German regulators have been turning a blind eye and the German government has propped them up, not least by supporting the system of sub-sovereign guarantees on which they depend. No wonder they are worried by Austria’s action. Undermining the guarantees not only destabilises Austria’s banking sector, it could prove catastrophic for Germany’s Landesbanken. So it would not be surprising if the German government backed Bavaria. They cannot really afford not to.

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“Bail in” is horrible, deceptive rhetoric. In fact, there is no such thing in reality.

Any so-called bail in is little more than bankruptcy without the formal court proceeding. Said another way, a bail in means this: STIFFING ONE’S CREDITORS.

In commercial banking, under commercial law, any deposit is a mutuum and not a depositum. Said another way, the bank customer sells cash or debt to a banker in a purchase and sale and buys a right of action against a banker. The banker sells bank credits and buys cash or debt.

Effectively then, a bail in means the authorities have voided the rights of action depositors hold against bankers.

As well, bankers get to stiff bondholders, the same as if a bankruptcy proceeding has gone down.

So anyone who parrots the phrase “bail in” is clueless, and in effect, helps to further destroy capitalism to save the hides of reckless bankers and mindless performance artists known as politicians.

Strictly, it is not a “right of action” that a creditor buys, but a claim on the bank’s assets. As I’m sure you know, in insolvency such claims are honored in seniority order. In this case, depositors will not be affected – it is more junior claims that are being asked to take a haircut. I should point out that this bank was nationalized for a song to prevent its disorderly failure, which would almost certainly have brought down BayernLB too (BayernLB was already badly damaged because of its exposure to US subprime). Had it been allowed to fail, sub debt holders could have lost their shirts six years ago – or, perhaps more likely, Austria would have been forced to honor their claims, causing severe damage to the sovereign (since HAA is not the only bank affected). I don’t think it would have been helpful to anyone for there to be another Ireland at the heart of Central Europe. Sometimes stiffing creditors, as you so colorfully put it, is the lesser of two evils.

Should anyone take solace in your words, “In this case, depositors will not be affected.”?

You fail to make a case as to why bankers and their shareholders should be protected from the vagaries of commerce as well as from superior intelligence and decision-making of competitors.

Stiffing creditors should go down in a court and only in court. That is why bankruptcy exists in commercial law. Otherwise, people are living under state-sanctioned, politician-supported piracy.

Assets should be sold off under direction of court to pay creditors. The banking management ought to be fired for gross incompetence.

Nationalization of banks puts banks into the hands of likely the most incompetent people on earth — government bureaucrats. Government bureaucrats are specialists in reading books, listening to university professors and believing upon both.

Every day, commercial bankruptcy happens. That is a win for everyone. Commercial bankruptcy means the incompetent stop wasting resources and get forced to work for those of superior intelligence.

As to a right of action, what do you think a right of action is? It’s a claim.

When the depositor sells his property in cash, that is, his right of ownership in cash, to a banker in a purchase and sale, the depositor buys a right of action against the banker. That is all he is doing.

The depositor buys a right of action against the banker to which the banker agrees to abide by should the banker fail to complete the contract between himself and the depositor.

In civil jurisprudence, a liability is the presence of power vested in someone that can be used against the one held liable. So, when someone is liable for debts, that one is liable to be sued for those debts.

Liability is correlative of a legal remedy. When it is civil, it accords with a right of action. When it is criminal, it accords with prosecution.

The banker is liable to be sued for failure to produce a sum of cash by the terms of the contract between the depositor and himself, a sum evidenced by a deposit slip, a passbook, or another kind of recorded entry.

Of course, both the banker and the depositor agree to an equivalent sum of cash in future and not the actual bills and coins surrendered by the depositor to the banker.

No-one should assume that because IN THIS CASE depositors are not affected, therefore depositors are universally safe. The European Bank Resolution Directive makes provision for uninsured depositors (i.e. those with deposits of over 100,000 euros in a single institution) to share in losses in the event of bank failure. You may think this unreasonable, but from January 2015 it will be EU law.

As to your article, in 1930, Americans of those days had money — coined metal by weight and fineness. Today, Americans only have legal tender cash — evidence of past deposits circulating in perpetuity.

Today, no one has money. As well, a deposit is a sale of cash as well as debt instruments to bankers in a purchase and sale for a right of action, as evidenced by bank credits.

So this bit about “convincing someone that his or her money is safe” lacks relevancy as 1) no one has money 2) depositor sell their property in cash to bankers who buy their property in cash by selling property in bank credits.

I’d put a link to my writing, but Forbes commenting seems to reject all replies with links. Google: Bizarro Theater

As to your article, in 1930, Americans of those days had money — coined metal by weight and fineness. Today, Americans only have legal tender cash — evidence of past deposits circulating in perpetuity.

Today, no one has money. As well, a deposit is a sale of cash as well as debt instruments to bankers in a purchase and sale for a right of action, as evidenced by bank credits.

So this bit about “convincing someone that his or her money is safe” lacks relevancy as 1) no one has money 2) depositor sell their property in cash to bankers who buy their property in cash by selling property in bank credits.

Upon reading your article, yes, central bankers ought to be the ones making good on insurance claims as they can conjure up checking account credits at will.

However, central bankers should not be the ones who set interbank lending rates and thus subsequent interest rates at all, as they cannot know, possibly what the price of future profits should be. Though it is true, that central bankers are privy to the state of member bankers and thus why they claim they should set rates.

Rather, a futures market ought to arise to set interest rates for degrees of deposit guarantees.

Do shortages or gluts of commodities among those who have futures markets ever break major crises or unwarranted expansions?

In short, though smart, bankers are no smarter than other kinds of property producers. They happen to be specialists in a particular kind of property production. In general, bankers take property that can’t readily be marketed and turn it into marketable property.

You can read all about them in my Theory of Trading Property for Profit, which is the only theory that describes commerce in reality as opposed to academic economics, which fails to describe reality at all.

Upfront: there is not one Austrian constitutional lawyer who believes that the law just passed will uphold before Austria’s Supreme Court.

To understand the current legal theatrics, one has to understand how this situation could develop in the first place. In the mid-1990s, the Governor of Carynthia, one of Austria’s smallest and weakest federal states (the unstoppable right-wing politician Jörg Haider) embarked on a course to turn his small state-owned HAA into THE financial power house in the Balkans. Loans by the millions were disbursed to questionable people/borrowers in Slovenia/Croatia while the shooting was still going on. Later it became billions. Those involved in Austrian banking, like myself, made no secret of their prediction that one day HAA would have to blow up.

Somehow, Jörg Haider and his bank pulled off a miracle: through continued mad growth, they could hide the fact that much of their portfolio was garbage. Sometimes it takes time to find out that a bank has no clothes. To prove a point: as late as the mid-2000s, an international institution (I forget which) named HAA as Austria’s best bank.

By that time, Haider and his bank seemed to have gotten cold feet in view of the gigantic guarantees which Carynthia had taken on for the HAA. They looked for a buyer but the formal selling process produced no interested party. Enter BayernLB and the State of Bavaria by about 2007.

BayernLB had long before lost its business model as a Landesbank. Even the Bavarian Finance Minister as representative of its largest shareholder made publicly fun of management that they were unable to develop a strategy. The opportunity to buy the Austrian BAWAG was seen as a solution and management was sure to get the deal because they had been 49%-shareholder of that bank in the past. Bad luck: the deal went to Cerberus and BayernLB had even more egg on its face. The Finance Minister commented: “They are even too dumb to buy a bank”.

Enter Jörg Haider. The sly Governor of Carynthia contacted BayernLB and communicated something like this: “Don’t worry about the BAWAG. In fact, be happy because I can offer you a much better bank!” Now picture this: Haider, who had previously failed to find a buyer for HAA in a normal privatization process, gets the Bavarians so excited that they: (a) enter into a bidding process when there was no other bidder; (b) agree to a price which no one is his right mind could understand; (c) agree to a 20-page Purchase Agreement which no lawyer in his right mind would have approved (neither did the lawyers of BayernLB); (d) pay a few millions of hush money to some of Haider’s pet projects as inducement for the sale; and (f) approve the deal not at a regular meeting of its supervisory board but, instead, get approval via ‘circulation’ because of the urgency of closing the deal before ‘someone else would get the bank’. At the end of the day, BayernLB ended up with about 78% of HAA. Their management went on a celebration spree.

Now, with new funding resources from BayernLB, the party for HAA really began. They more than doubled their balance sheet within two years. They kept Bavarian influence/control at bay with the argument that the Balkan business was something that required special expertise which BayernLB did not have. By 2009, it began to dawn on BayernLB what they had done and how much of a loss potential there was for the then already hurting (thanks to sub-prime) BayernLB. Now the time had come for the Bavarians to return to Austria the fast one which the Governor of Carynthia had pulled on them before. Regrettably, the sly Haider was dead by then and Austria’s negotiator was the Finance Minister, a man coming out of the Farmers’ Association (and not out of Wall Street…).

In a night from Sunday/Monday in early December 2009, the deal was struck. Records published in the meantime show what BayernLB’s negotiation position had been: they had totally ruled out a bankruptcy and expected to enter into a long-term agreement with Austria to wind down the bank and eventually share the losses. However, Bavarians can be sly, too, and they started out by insisting that, as of Money morning, they would no longer support HAA. If that meant bankruptcy, so be it. Needless to say: the Austrian Finance Minister of agrarian backround (who had no legal advice present during the negotiations whereas BayernLB had Freshfields in tow) fell and agreed to nationalize the bank. That way, he made Austria responsible to assume losses which, at the end of the day, will approach a total of almost 10 BEUR. Had he struck a deal to share losses with the Bavarians according to ownership, those losses would have been a little over 2 BEUR. The cost to Austrian tax payers of having the wrong negotiator? Well, about 8 BEUR.

Since then, the Austrian government has provided ample material for a book titled “How not to wind down a bank”. The unbelievable incompetence of entering in such a deal was, unbelieveably, exceeded every step along the way. It took almost 4 years (and an ultimatum by the EU) for the government to intiate real action. The then Finance Minister commissioned Oliver Wyman for an expertise about the alternatives. OW presented several alternatives and concluded that an insolvency of HAA would save Austrian tax payers about 5 BEUR. Most of the involved decision makers in and outside government felt it necessary to make public that they hadn’t even read the study because a bankruptcy of HAA was out of the question considering Austria’s creditworthiness and reputation. They opted for a bad bank solution where tax payers would carry 100% of the losses. A law to that effect was passed with the only shortfall that in order to establish the bad bank, approval of BayernLB is required (get this: Austria had agreed to let BayernLB off the hook by nationializing HAA but, at the same time, they granted BayernLB a veto right on all major decisions as long as they had funding out to HAA!). At that time, BayernLB announced that no one had talked to them about such approval as yet and that they saw now reason why they should approve.

After this law was passed, there was substantial public uproar. This provoked the Finance Minister to embark on a unique new strategy, some like: “Now that we have formally let creditors and former owners off the hook, we are going to enter into tough negotiations with them to share in the losses”. The reaction from those parties must have been “go fly a kite”, which prompted the government to pursue the strategy of a post-facto arbitrary bail-in. The law has not yet passed parliament.

So here you have it: a government which had ruled out a normal market event, i. e. the bankruptcy of HAA, because of its consequences for the creditworthiness and reputation of the country decided that the more credible course of action would be the precedent of the state disowning bond holders by declaring some guarantees of one of its federal states retroactively invalid. And to do that not for all of the roughly 14 BEUR of such guarantees but only for a portion of 900 MEUR thereof. Speaking of getting litte bang for the buck…

Austria’s decisions were exclusively driven by considerations of how to appease voters, disregarding completely professional and responsible conduct as well as respect for the law. The price which Austria will eventually have to pay for that (at the latest when the Austrian Supreme Court declares the respective law as unconstitutional) will be phenomenal compared to even the worst of all the other alternatives. Sadly, I have to say as an Austrian, that we deserve that.